The scenes from the streets of Bombay, Delhi, and other big Indian cities have shocked India. As medical students and young doctors peacefully protested a government initiative to reserve another share of seats in colleges and universities for members of lower castes, police set upon the marchers, beating many of them with truncheons.

Even more shocking to many, officials later claimed that although a few students were hospitalized, the police had not used undue force. One politician even dismissed the injuries as "just a few broken bones." Such responses have spurred students and young professionals across the country to join in the protests.

ANCIENT GRIEVANCES. Rarely has an issue so polarized India. The country's 10 million undergraduate students see the already limited number of spots in universities shrinking further. Those in favor of the affirmative action program -- generally referred to as "reservations" -- say such measures are necessary to make up for 3,000 years of a caste system that allowed Hindu society to become stratified into the privileged few and the excluded many.

A loosely organized guild system, based on professions such as priests, princely warriors, leather-workers, blacksmiths, weavers, and cowherds, eventually grew into the caste system. For centuries, the system allowed educated Brahmin priests to wield enormous power over kingdoms won by warriors and made wealthy by merchants. They exploited the rest of the uneducated populace, consigning them to the underclass by virtue of their birth. Intermarriage and even socializing between the various castes was forbidden.

Officially, the caste system was abolished when India achieved independence from British rule in 1947. Early Indian leaders such as Mahatma Gandhi agitated against it, and encouraged the lower castes to voice their grievances and participate in public life. India's first prime minister, Jawaharlal Nehru, advocated affirmative action to overcome the disparities. Two decades ago, India began reserving for the lowest classes -- including the untouchables, or Dalits -- 22% of government jobs and places in state schools and colleges.

VOTING BLOC. The program has benefited many. India's past president, K.R. Narayanan, and current president, A.P.J. Kalam, a scientist who also rose to head India's nuclear establishment, are from lower castes. And the measures empowered the lower castes politically. As they became aware of their rights, they became a powerful voting bloc.

Still, though politically empowered, the reservations did little to economically empower the underprivileged masses out of poverty. Today, the caste system persists and the ranks of the lower castes have swelled as India's poor population has mushroomed. Narendra Jadhav, a Dalit who is the chief economist of India's central bank, the Reserve Bank of India, says reservations are all the more necessary today "because of the inability of the system to be just and fair."

Today's debate is about extending such privileges to other lower-caste groups such as cowherds, leather workers, and butchers. If implemented, such a policy would add, on top of the earlier 22%, another 28% of seats in colleges reserved for students from lower castes, making for a total of 50%. These lower castes especially want entrée into the new economy, which they feel has benefited the privileged educated classes who attend highly competitive institutions such as the Indian Institutes of Technology (IIT) and the Indian Institutes of Management.

BRAIN DRAIN. The anti-reservationists argue that reserving seats at India's few merit-based and uncorrupted institutes of higher learning will dilute standards, bring down student morale, and jump-start a brain drain that had just started to reverse. The new India has been built on the education provided at institutes such as the IIT. Furthermore, they point to the chronic lack of qualified candidates for the posts in Indian universities reserved for professors from lower castes. Finally, they argue, reservations at the university level won't work until India improves primary and secondary school education.

Indeed, despite the excellence of India's top schools, most of the nation remains far behind. Of the 202 million children who enroll in the country's 1 million schools every year, barely 15% make it to high school, and just half of those -- about 14 million -- graduate, according to Pratham, a foundation that focuses on education. Then there is an acute shortage of colleges in the country, and a lack of vocational training institutes. Of the 370,000 engineers who graduate annually, just 200,000 are of good quality, says Mohandas Pai, board member for human resources at software and services house Infosys . About 140,000 of those will be hired by software companies this year. "so what's left for the rest of Indian industry?" he asks.

The shortage of colleges has prompted bright Indian students to go overseas. Some 150,000 are studying in the U.S., Britain, and Australia, spending an average of $4.5 billion a year. That's more than twice New Delhi's $2 billion annual budget for higher education. Reservations will simply encourage the brain drain, especially from the middle classes and elite. "If these stakeholders aren't in the system, government becomes complacent," says Ravinder Kaur, an associate professor of sociology at the Indian Institute of Technology, New Delhi.

But the prospect of easier access to the IIT and other top schools has revved up the lower castes. Bhanwar Meghwanshi is a Dalit from Rajasthan's weaver caste who is now editor of Diamond India, a Hindi magazine dedicated to secularism and equality. He was educated in the village and didn't reap any advantages from reservations. Now, even though he is more educated than the upper castes in his village, as a Dalit, he is barred from entering the main village temple, where only upper castes are allowed.

Meghwanshi says that if the new reservations are to really work, the "creamy layer" of lower castes -- those whose parents have already benefited from such policies and are integrated into the Indian mainstream -- "must be kept out, because the very, very poor still don't even know this is being done for them."

LOSING INVESTORS. Many economists are worried about the effect of reservations on India's competitiveness. Surjit Bhalla, an economist who often advises New Delhi, worries that reservations will become a problem for investors. If there isn't enough qualified talent available in India, they "will not hesitate to go to China, Vietnam, even Bangladesh and Pakistan."

Subir Gokarn, chief economist at Crisil, India's largest rating agency, says the government should be more concerned about creating blue-collar jobs for India's burgeoning youth than about reserving scarce spots at the top end. He suggests converting the caste system back into a guild system, encouraging those with traditional skills to pursue them. "Caste's positive aspect should be the basis of India's competitive strength in manufacturing," he says. He points to India's successful auto parts sector in the southern state of Tamil Nadu, where private industry has built on an available bank of blacksmiths and iron smiths.

Now, even as India is in turmoil over reservation of university seats, New Delhi is talking of yet another divisive measure: reserving half the jobs in the private sector for the lower castes. "That sort of coercive measure will really affect India's competitiveness," says Ram Guha, a well-regarded Indian author and historian on the subject. "We will be worse off than in the socialist economy we once used to be."

The labour arbitrage advantage India has over the UK will last for at least another 30 years, while India will also retain its low-cost wage advantage over the US for at least another 18 years, according to the report.

Low-cost offshore locations such as India and the Philippines are aggressively making moves to minimise the impact of wage inflation by encouraging the expansion of the quality and size of the relevant workforces and by developing more low-cost offshore locations, the report says.

IT suppliers in India, for example, are lowering their costs by moving to 'tier two' cities--away from traditional high-tech centres such as Bangalore - and opening delivery centres in other countries.

Stephen Dunn, managing principal at Everest, said in the report: "Offshoring will retain a substantial labour arbitrage for the next 30 years between the UK and key low-cost destinations such as India and the Philippines. While current inflationary pressures exist, reports of 18 per cent salary growth in key destinations are overstated."

A separate study out this week also found that more than three-quarters of research and development facilities opened by western companies over the next three years will be located in China and India.